Saturday, June 21, 2008

Post Mortem: Berkshire Acquires Gen Re, 1998. Part 1

Jeff Matthews questions the wisdom of Berkshire Hathaway acquiring General Re in 1998 for stock.  This is a difficult question, but as with most Berkshire deals, is worth pondering. First things first -- any acquisition involves what one might call operational risk for lack of a better term. And naturally, it is the unknown unknowns that are always the worst. In this case, the significant regulatory issues that have plagued Gen Re's management in the decade following the sale, and in the process, became a significant distraction for Berkshire as well as a reputational issue.    I will duck this one, at least for now and focus on the financial aspects of the deal.

There are three parts to this analysis:  What they got in 1998, what they gave in 1998, and how the pieces have performed in the subsequent decade.  Part 1 is what Berkshire got.  All the information needed is in a 1998 SEC Form S-4.

"On June 19, 1998, the last full trading day on the New York Stock Exchange prior to the public announcement of the Transactions General Re common stock closed at $220 1/4 per share, and Berkshire Class A Common Stock closed at $80,900 At the exchange ratio of 0.0035 shares of Berkshire Class A Common Stock per share of General Re Common Stock, the equivalent price of a share of General Re Common Stock on June 19, 1998 was $283.15."

The exchange ratio means that Berkshire issued 267,750 Class A share equivalents to get General Re.  Let's take a look at a summarized pro forma balance sheet as of 6/30/1998:




This is a little daunting, so I have created a horribly simplified balance sheet for Gen Re:


The reason that I am showing the balance sheet is that the concept of float seems so simple in the Berkshire Hathaway Chairman's letters, but so slippery when it is discussed.  Liabilities for policy holder funds that will be paid in the future are booked today.  When you book the liability, you also book an offsetting asset.  That asset starts out as cash.  The reason float is good is that you have an asset in cash today and a liability payable in the future.  There is no segregated asset referred to as "float" in the left hand column.  The only way to determine the quantity of float is to look at the liabilities.  Float is buried in the asset column but can only be quantified using the corresponding segregated liabilities.  

First, you can ignore about $10 billion in assets and liabilities associated with Gen Re's financial business (included in the 'other' category).  Secondly, the float is equal to the loss and loss adjustment expenses (which will be paid in the future) and the unearned premium, less the portion of those that haven't been collected.  According to Warren Buffett, the Gen Re float is $15 billion.  In addition, the shareholder's equity (less the goodwill) is also investable.  That's another $7.5 billion.  

For each Berkshire A share, the Gen Re investible float is equal to the $15 billion divided by the 267,750 shares or $56,022 per A share.  Including the tangible equity, you get $84,120 per A share.  

Buffett sold Gen Re's equity portfolio*, so the entire investable amounts were bonds and cash.  So for every new A share issued in 1998, Buffett got $85,000 to invest.  Now insurers are regulated and the investments are subject to some constraints.  In addition, the liabilities proved to be inaccurately valued, effectively increasing the cost of the deal by $2 to $3 billion.  Nevertheless, Buffett got his hands on a lot of cash for each new A share issued.

As far as the theoretical option of simply doing a secondary offering and selling 267,750 shares at $80,000 per share, forget about it.  Berkshire was selling for 2.7 times a book value of less then $30,000, and a lot of that book value was simply publicly traded large cap stocks.  The historical stock prices for Berkshire prior to the merger were:


So you can see that the stock had not sold for over $50k per A share until 1998 and the $84,000 would prove to be a rich valuation.  Regardless of his brilliance, giving Buffett $80k/share to invest $40k/share would be a tough sell.

This is the end of part 1.  Part 2 will examine what BRK gave up when it traded its shares for Gen Re's.  

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* From the 1998 Chairman's Letter to Shareholders, "Once we knew that the General Re merger would definitely take place, we asked the company to dispose of the equities that it held. (As mentioned earlier, we do not manage the Cologne Re portfolio, which includes many equities.) General Re subsequently eliminated its positions in about 250 common stocks"

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